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Bonn Summer SchoolAdvances in Empirical Macroeconomics
Karel Mertens
Cornell, NBER, CEPR
Bonn, June 2015
In God we trust, all others bring data.
William E. Deming (1900-1993)
Angrist and Pischke are Mad About Macro
(2010 JEP, The Credibility Revolution in Empirical Economics: HowBetter Research Design Is Taking the Con out of Econometrics)
Sims, JEP 2010, Comment on Angrist and Pischke: But economics is notan experimental science
Overview
1. Estimating the Effects of Shocks Without Much Theory
1.1 Structural Time Series Models1.2 Identification Strategies
2. Applications to Fiscal Shocks
2.1 Tax Policy Shocks2.2 Government Spending Shocks2.3 Austerity Measures
3. Two Difficulties in Interpreting SVARs
3.1 Noninvertibility3.2 Time Aggregation
4. Systematic Tax Policy and the ZLB
1. Estimating the Effects of Shocks Without Much Theory
General Approach:
1. Using observables zt , fit a model of expectations E [zt | It−1]
2. Identify meaningful shocks from innovations zt − E [zt | It−1].
3. Estimate dynamic causal effects of shocks/variance contributions.
It : information available to economic decision makers at time t.
1.1 Structural Time Series Models
State Space (SS) Representation
The solution of stationary linear models can generally be written as
st = Gst−1 + Fetzt = Ast−1 +Det
st is a m × 1 vector of state variableset+1 is an l × 1 vector of uncorrelated white noise, or structural shocks
E [et ] = 0 , E [ete′t ] = I , E [ete
′s ] = 0 for s 6= t
zt is an n × 1 vector of variables of interestG is m ×m, F is m × l , A is n ×m and D is n × l
Stability and Stationarity
The m ×m matrix G has all eigenvalues less than one in modulus, i.e.
det(M − λI ) 6= 0 for | λ |≥ 1, or equivalently
det(I −Mz) 6= 0 for | z |≤ 1
st follows a stable VAR(1) process
st and zt are stationary stochastic processes, i.e. the first and secondmoments are time invariant.
Lag Operator
Define the lag operator L, i.e. Lkxt = xt−k .
st = Gst−1 + Fet(I − GL)st = Fet
st = (I − GL)−1Fet
st =∞∑i=0
G iFet−i
Time Series Representations
Moving Average (MA) Representation
MA(q) : zt = M(L)υt =
q∑i=0
Miυt−i
where M(L) =M0 +M1L + ...+MqLq and innovations process υt
E [υt ] = 0 , E [υtυ′t ] = Σ , E [υtυ
′s ] = 0 for s 6= t
Wold Representation TheoremEvery stationary process zt can be written as an MA(∞).(plus deterministic terms).
Stationary linear models for zt and et can always be written as MA(∞)
zt = M∗(L)et =∞∑i=0
M∗i et−i
Given an SS representation G,F ,A,D,
zt =∞∑i=1
AG i−1Fet−i +Det
= A(I − GL)−1Fet−1 +Det=
(D +A(I − GL)−1FL
)et
such that M∗0 = D and M∗i = AG i−1F for i ≥ 1
Assume n = l and Stochastic Nonsingularity:
D is an n × n invertible matrix.
We can write a ‘structural’ MA
zt = M(L)υt =∞∑i=0
Miυt−i
with υt = Det , Σ = DD′ , M0 = I
zt =(I +A(I − GL)−1FD−1L
)υt
such that Mi = AG i−1FD−1 for i ≥ 1
Time Series Representations
Vector Autoregressive Moving Average Representation
VARMA(p,q) : B(L)zt = M(L)υt
where
B(L) = I − B1L− ...− BpLp
M(L) = M0 +M1L + ...+MqLq
E [υt ] = 0 , E [υtυ′t ] = Σ , E [υtυ
′s ] = 0 for s 6= t
Starting from the MA representation of our linear models,
zt = A(I − GL)−1Fet−1 +Det
Suppose n = m and A is invertible,
A−1zt = (I − GL)−1Fet−1 +A−1Det(I − GL)A−1zt = Fet−1 + (I − GL)A−1Det
Assuming D invertible we obtain a structural VARMA(1,1),
zt = AGA−1zt−1 + υt −A(G − FD−1A
)A−1υt−1
’Structural’ here means
υt = Det
Time Series Representations
Vector Autoregressive Representation
VAR(p) : B(L)zt = υt
⇒ zt = B1zt−1 + . . .+ Bpzt−p + υt
where
B(L) = I − B1L− ...− BpLp
E [υt ] = 0 , E [υtυ′t ] = Σ , E [υtυ
′s ] = 0 for s 6= t
Fernandez-Villaverde, Rubio-Ramirez, Sargent and Watson (2007):
Start from the SS representation of our models,
st = Gst−1 + Fetzt = Ast−1 +Det
Assume n = l and Stochastic Nonsingularity:
D is an n × n invertible matrix.
When D is nonsingular,
et = D−1(zt −Ast−1)
Substituting
st =(G − FD−1A
)st−1 + FD−1zt
Invertibility (in the Past):
The eigenvalues of G − FD−1A are strictly less then one in modulus.
Under this condition we can write
st =∞∑i=0
(G − FD−1A
)i FD−1zt−i
Substituting
zt =∞∑i=1
A(G − FD−1A
)i−1 FD−1zt−i +Det
such that
Bi = A(G − FD−1A
)i−1 FD−1υt = Det
In practice, lag truncation: zt =∑p
i=1 Bizt−i + υt
Stochastic Nonsingularity: No big deal (measurement errors)
Invertibility (in the Past): Choice of zt is important!If the invertibility condition does not hold and we estimate a VAR:
υt 6= Det
Alternatively, start from the MA representation
zt = M(L)υt
or VARMA representation
B(L)zt = M(L)υt
and invert M(L) to obtain a VAR representation.
(Note: it is assumed that M(L) is a square matrix of rational functions.)
S(L)B(L)zt = S(L)M(L)υt
M(L) is invertible in the past,
i.e. there is an S(L) such that S(L)M(L) = I and S(L) only hasnonnegative powers of L,
if det(M(L)) 6= 0 for | L |≤ 1.
See Hansen and Sargent (1980, 1991), Lippi and Reichlin (1993), Forniand Gambetti (2014)
MA representation of our models:
zt =(I +A(I − GL)−1FD−1L
)υt
Using the matrix determinant lemma,
det(I +A(I − GL)−1FD−1L
)= det
(I − (G − FD−1A)L
)/det(I − GL)
The condition that
det(I − (G − FD−1A)L
)6= 0 for | L |≤ 1
is equivalent to
det((G − FD−1A)− Iz
)6= 0 for | z |≥ 1
or G − FD−1A must have all eigenvalues strictly less then one inmodulus (same as Fernandez-Villaverde et al. 2007).
VARMA representation of our models:
(I −AGA−1L)zt =(I −A
(G − FD−1A
)A−1L
)υt−1
The condition that
det(I −A
(G − FD−1A
)A−1L
)6= 0 for | L |≤ 1
is equivalent to
det((G − FD−1A
)− Iz
)6= 0 for | z |≥ 1
or G − FD−1A must have all eigenvalues strictly less then one inmodulus (same as Fernandez-Villaverde et al. 2007).
Example: New Keynesian Model
See Clarida, Gali and Gertler (1999) and the Woodford (2003) and Gali(2008) books
Et∆ygapt+1 = φππt − Etπt+1 − ut (Eq. Euler)
πt = κygapt + βEtπt+1 − vt (Phillips curve)
where κ > 0, φπ > 1, 0 ≤ β < 1
ygapt : output gap , πt : inflation
vt : cost push shocks
ut : other shocks (technology, govt spending, taxes, monetary policy,...)
ut and vt are stationary exogenous processes
Iterating forward,[ygapt
πt
]= Et
∞∑j=0
C−(j+1)
[ut+j
vt+j
]where
C−1 =1
1 + φπκ
[1 1− βφπκ β + κ
]Note C−1 has eigenvalues strictly less than one in modulus. Why?
Suppose the shocks follow a VAR(1) process.[utvt
]︸ ︷︷ ︸
st
= Λ︸︷︷︸G
[ut−1vt−1
]+ Ω︸︷︷︸F
et
[ygapt
πt
]︸ ︷︷ ︸
zt
=∞∑j=0
C−(j+1)Λj
[utvt
]
= (C − Λ)−1 Λ︸ ︷︷ ︸A
[ut−1vt−1
]︸ ︷︷ ︸
st−1
+ (C − Λ)−1 Ω︸ ︷︷ ︸D
et
Note that G − FD−1A = 0.
State Space representation:[utvt
]= Λ
[ut−1vt−1
]+ Ωet[
ygapt
πt
]= (C − Λ)−1 Λ
[ut−1vt−1
]+ (C − Λ)−1 Ωet
Moving Average Representation[ygapt
πt
]=∞∑i=0
(C − Λ)−1 ΛiΩet−i
VAR/VARMA Representation[ygapt
πt
]= (C − Λ)−1 Λ (C − Λ)
[ygapt−1πt−1
]+ (C − Λ)−1 Ωet
Reduced Form Parameters
SS : st = Gst−1 +Hυt G,A,H,Σzt = Ast−1 + υt
MA(q) : zt = M(L)υt Mi ,Σ
VARMA(p,q) : B(L)zt = M(L)υt Bi ,Mi ,Σ
VAR(p) : B(L)zt = υt Bi ,Σ
where E [υt ] = 0 , E [υtυ′t ] = Σ , E [υtυ
′s ] = 0 for s 6= t
Note: SS, MA and VARMA require additional normalizations.
When well-specified, these are all models that allow us to separateexpectations E [zt | It−1] and innovations υt = zt − E [zt | It−1].
Estimation of Reduced Form Parameters
VAR estimation
Some references:
Hamilton, 1994, ’Time Series Analysis’
Luetkepohl, 2005, ‘A New Introduction to Time Series Analysis’
Brockwell and Davis, 2006,‘Time Series: Theory and Methods’
Aoki, 1990, ‘State Space Modeling of Time Series’
Durbin and Koopman, 2012, ‘Time Series Analysis by State SpaceMethods’
Local Uniquess
In matrix form
Et
[ygapt+1
πt+1
]= C
[ygapt
πt
]−[
utvt
], C ≡ 1
β
[β + κ βφπ − 1−κ 1
]The companion matrix C has the characteristic polynomial
P(ϕ) = ϕ2 − tr(C)ϕ+ det(C)
tr(C) = 1 + 1/β + κ/β > 1
det(C) = (1 + κφπ)/β > 1
which has roots outside the unit circle if tr(C) < 1 + det(C) or
φπ > 1 (Taylor Principle)
Back
Estimating a VARSample of T + p observations of an n × 1 vector zt :
zt−p+1, zt−p+2, . . . , zT−1, zT
Define the n × T matrix z such that:
z =[z1 z2 · · · zT
]Define a np × 1 vector Zt :
Zt =
zt−1zt−2
...zt−p
Let Z be a np × T matrix collecting T observations of Zt :
Z =[Z1 Z2 · · · Zp
]
Let υ be a n × T matrix of n × 1 residuals υt :
υ =[υ1 υ2 · · · υT
]Let B be a n × np matrix of coefficients:
B =[B1 B2 · · · Bp
]Introduce the vectorization operator:
z = vec(z)
u = vec(υ)
Where z is a nT × 1 vector of the stacked columns of z . Thevariance-covariance matrix of u is:
Var(υ) ≡ Σ = IT ⊗ Σ
Generalized Least Squares
Re-write the reduced form VAR(p) as:
z = BZ + u
Or as:
z = (Z ′ ⊗ In)β + u
Where ⊗ is the Kronecker product. We can estimate β with GeneralizedLeast Squares (GLS):
u′Σ−1u = (z− (Z ′ ⊗ In)β)′Σ−1(z− (Z ′ ⊗ In)β)
= z′Σ−1z + β′(Z ⊗ In)Σ−1(Z ′ ⊗ In)β − 2β′(Z ⊗ In)Σ−1z
= z′(IT ⊗ Σ−1)z + β′(ZZ ′ ⊗ Σ−1)β − 2β′(Z ⊗ Σ−1)z
First order condition:
2(ZZ ′ ⊗ Σ−1)β − 2(Z ⊗ Σ−1)z = 0
The GLS estimator is therefore:
β = ((ZZ ′)−1Z ⊗ In)z
This is the same as OLS or ML.
Asymptotic normality:
√T (β − β)
d→ N (0, Γ−1 ⊗ Σ)
where Γ = plimZZ ′/T and the estimators are
Γ =ZZ ′
T
Σ =1
T − np − 1z(IT − Z ′(ZZ ′)−1Z )z ′
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